Final Course Paper 2 Strategic Financial Management Chapter 2 Part 8. CA. Anurag Singal

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1 Final Course Paper 2 Strategic Financial Management Chapter 2 Part 8 CA. Anurag Singal

2 Internal Rate of Return Miscellaneous Sums

3 Internal Rate of Return (IRR) is the rate at which NPV = 0

4 XYZ Ltd., an infrastructure company is evaluating a proposal to build, operate and transfer a section of 35 kms. of road at a project cost of Rs 200 crores to be financed as follows: Equity Shares Capital Rs 50 crores. Loans at the rate of interest of 15% p.a. from financial institutions Rs150 crores. The Project after completion will be opened to traffic and a toll will be collected for a period of 15 years from the vehicles using the road. The company is also required to maintain the road during the above 15 years and after the completion of that period, it will be handed over to the Highway authorities at zero value.

5 It is estimated that the toll revenue will be Rs 50 crores per annum and the annual toll collection expenses including maintenance of the roads will amount to 5% of the project cost. The company considers to write off the total cost of the project in 15 years on a straight line basis. For Corporate Income tax purposes the company is allowed to take 10% on WDV basis. The financial institutions are agreeable for the repayment of the loan in 15 equal annual installments consisting of principal and interest. (a) Calculate Project IRR and Equity IRR. Ignore Corporate taxation. (b) Explain the difference in Project IRR and Equity IRR

6 Rs 200 crore= Rs 40 crores * (1 + r) 15 (a) Computation of Project IRR : Project IRR is computed by using the following equation: CO 0= CF i * (1+R)^N Where, CO 0 = Cash outflow at time zero CF i = Net cash inflow at different points of time N = Life of the project and R = Rate of discount (IRR) Now, CO 0 = Rs 200 crores CF i = Rs 40 crores p.a. for 15 years (Refer to working note (i)) Therefore,

7 Working Notes: (i) Net cash inflow of the project Cash inflow (Rs ) Toll revenue 50 crore p.a. for 15 years Cash outflow Toll collection expenses including maintenance of the roads 10 crore p.a. for 15 years (5% of Rs 200 crore) Net cash inflow 40 crores p.a. for 15 years Note: Since corporate taxes is not payable. The impact of depreciation need not be considered.

8 The value of IRR of the project: 1. An approximation of IRR is made on the basis of cash flow data. A rough approximation may be made with reference to the payback period. The payback period in the given case is 5 years i.e. 200 crores / 40 crores. From the PVAF table the closest figures are given in rate 18% (5.092) and the rate 19% (4.876).

9 2. The estimate of IRR cash inflow of the project for both these rates is as follows: At 18% = Rs 40 crores PVAF (18%, 15 years) = Rs 40 crores = Rs crores At 19% = Rs 40 crores PVAF (19%, 15 years) = Rs 40 crores = Rs crores

10 3. The exact IRR by interpolating between 18% and 19% is worked out as follows: IRR = 18% + Rs crores Rs 200 crores 1% Rs crores - Rs crores = 18% + Rs 3.68 crores 1% Rs 8.64 crores = 18% % = 18.43% Therefore, the IRR of the project is 18.43%.

11 Computation of Equity IRR Equity IRR is computed by using the following equation: Cash inflow at zero date from equity shareholders = Cash inflow available for equity shareholders*(1+r)^n Where, r = Equity IRR n = Life of the project Here, Cash inflow at zero date from equity shareholders = Rs 50 crore Cash inflow for equity shareholders = Rs14.35 crore p.a. (Refer to working notes) Therefore: Rs 50 crores = Rs crores (1 + r)^15

12 The value of equity IRR of the project is calculated as follows: 1. An approximation of IRR is made on the basis of cash flow data. A rough approximation may be made with reference to the payback period. The payback period in the given case is ( Rs 50 crores / Rs crores) From the PVAF table the closest figure may be about 25% and 30%. This means the equity IRR of project must be between 25% and 30%.

13 2. The estimated NPV of the project at 25% = Rs crore X = = crore The estimated NPV of the project at 30% = Rs crore X = = Rs crore 3. IRR by using Interpolation Formula will be = 25% X5% = 25% + X *5% = 25%+ 3.17% =28.17%

14 Working Note (ii) Equated annual instalment (i.e. principal + interest) of loan from financial institution: Amount of loan from financial institution = Rs150 crores Rate of interest = 15% p.a. No. of years = 15 Cumulative discount factor for 1-15 years =5.847 Hence, equated yearly instalment will be Rs 150 crores/5.847 i.e. Rs crores.

15 (iii) Cash inflow available for equity shareholders (Rs cr) Net cash inflow of the project Refer to working note (i)] Equated yearly installment of the project [Refer to working note (ii)] Cash inflow available for Equity Shareholders crores

16 (b) Difference in Project IRR and Equity IRR: The project IRR is 18.4% whereas Equity IRR is 28%. This is attributed to the fact that XYZ Ltd. is earning 18.4% on the loan from financial institution but paying only 15%. The difference between the return and cost of funds from financial institution has enhanced equity IRR. The 3.4% (18.4% - 15%) earnings on Rs 150 crores goes to equity shareholders who have invested Rs 50 crore i.e. 3.4% 150 crores / 50 crores = 10.2% is added to the project IRR which gives equity IRR of 28%.

17 X Ltd. an existing profit-making company, is planning to introduce a new product with a projected life of 8 years. Initial equipment cost will be Rs 120 lakhs and additional equipment costing Rs 10 lakhs will be needed at the beginning of third year. At the end of the 8 years, the original equipment will have resale value equivalent to the cost of removal, but the additional equipment would be sold for Rs 1 lakhs. Working Capital of Rs 15 lakhs will be needed. The 100% capacity of the plant is of 4,00,000 units per annum The production and sales volume expected are as under:

18 Year Capacity Utilization (%) A sale price of Rs 100 per unit with a profit-volume ratio of 60% is likely to be obtained. Fixed Operating Cash Cost are likely to be Rs 16 lakhs per annum. In addition to this the advertisement expenditure will have to be incurred as under: Year Expenditure in Rs lakhs each year The company is subject to 50% tax, Straight-line method of depreciation, (permissible for tax purposes also) and taking 12% as appropriate after tax Cost of Capital, should the project be accepted?

19 (a) Computation of initial cash outlay (Rs in lakhs) Equipment Cost 120 Working Capital

20 Calculation of Cash Inflows: Year Sales in units 80,000 1,20,000 3,00,000 2,00,000 ` 60 p.u. (Rs) (Rs) (Rs) (Rs) 48,00,000 72,00,000 1,80,00,000 1,20,00,000 Fixed cost 16,00,000 16,00,000 16,00,000 16,00,000 Advertisement 30,00,000 15,00,000 10,00,000 4,00,000 Depreciation 15,00,000 15,00,000 16,50,000 16,50,000 Profit/(loss) (13,00,000) 26,00,000 1,37,50,000 83,50,000 50% Nil 13,00,000 68,75,000 41,75,000 Profit/(loss) after tax (13,00,000) 13,00,000 68,75,000 41,75,000 Add: Depreciation 15,00,000 15,00,000 16,50,000 16,50,000 Cash Inflow 2,00,000 28,00,000 85,25,000 58,25,000

Computation of Present Value of Cash Inflows Year CIF PV Factor @ 12% Present Value of CIF (Rs) 1 2,00,000 0.893 1,78,600 2 28,00,000 0.797 22,31,600 3 85,25,000 0.712 60,69,800 4 85,25,000 0.

21 Computation of Present Value of Cash Inflows Year CIF PV 12% Present Value of CIF (Rs) 1 2,00, ,78, ,00, ,31, ,25, ,69, ,25, ,21, ,25, ,33, ,25, ,53, ,25, ,32, ,25, ,53,300 WC 15,00, ,06,000 SV 1,00, ,400 2,73,21,450 PV of COF 1,35,00,000 Additional Investment at the end of Year 2 (Rs. 10,00, ) 7,97,000 1,42,97,000 NPV 1,30,24,450 Recommendation: Accept the project in view of positive NPV.

22 DL Services is in the business of providing home Services like plumbing, sewerage line cleaning etc. There is a proposal before the company to purchase a mechanized sewerage cleaning line for a sum of Rs 20 lacs. The life of the machine is 10 years. The present system of the company is to use manual labour for the job. You are provided the following information: Cost of machine 20 lakhs Depreciation 20% p.a. straight line Operating cost Rs 5 lacs per annum

23 Present system Manual labour 200 persons Cost of Manual labour Rs 10,000 per person p.a. The company has an after tax cost of funds of 10% per annum. The applicable rate of tax inclusive of surcharge and cess is 35%. Based on the above you are required to: (a) State whether it is advisable to purchase the machine. (b) Compute the savings/additional cost as applicable, if the machine is purchased.

24 Present System Cost per annum Rs 200 Rs 10,000 per annum 20,00,000 Cumulative Annuity factor at 10% Present value of cash outflow over a period of ten 122,89,200 years at 10% Tax benefit at 35% for 10 years 43,01,220 Net cost over ten years 79,87,980 If Machine is purchased Cost per annum Rs Cost of Machine 20,00,000 Depreciation per annum 4,00,000 Annual cost of operation 5,00,000 Present value of operating cost for 10 years at 10% 30,72,300

25 Cost per annum Amount in Rs Tax saving on operating cost at 35% for 10 years 10,75,305 Net operating cost (Rs 30,72,300-10,75,305) 19,96,995 Annuity factor for 5 years at 10% Tax saving on depreciation at 35% (19,96,995/3.7908) 5,30,712 Summary Outflow on machine 20,00,000 Less: Tax saving on depreciation of Machine (5,30,712) Add: Operating cost over 10 years 19,96,995 Total cost of machine over 10 years 34,66,283 Total saving (79,87,980-34,66,283) 45,21,697 Since there is a saving of Rs lacs it is advisable to purchase the machine.

26 XYZ Ltd. is considering a project for which the following estimates are available: Particulars Amount in Rs Initial Cost of the project 10,00,000 Sales price/unit 60 Cost/unit Sales volumes Year 1 Year 2 Year ,000 units 30,000 units 30,000 units Discount rate is 10% p.a. You are required to measure the sensitivity of the project in relation to each of the following parameters: 1. Sales Price/unit 2. Unit cost 3. Sales volume 4. Initial outlay and 5. Project lifetime Taxation may be ignored.

27 Calculation of NPV NPV = - 10,00, , , ,000x = - 10,00, ,63, ,95, ,50,789 = 13,10,293 10,00,000 = Rs 3,10,293 Measurement of sensitivity is as follows: (a)sales Price:- If sale Price decreased by say 10%, then NPV (at Sale Price of Rs 60 Rs 6 = Rs54) NPV = -10,00, (1.1) (1.1) 2 (1.1) 3 = -10,00,000 +2,54, ,47, ,15,552 = -82,796 NPV decrease (%) = (3,10,293-(-82,796))/3,10,293 X 100 = %

28 (b) Unit Cost:- If unit cost increased by say 10%. The new NPV will be as follows: NPV = -10,00, (1.1) (1.1) 2 (1.1) 3 = -10,00,000 +2,90, ,96, ,60,631 = 48,234 NPV decrease (%) = 3,10,293-(48,234)/310,293X 100 = 84.46%

29 (c) Sales volume:- If sale volume decreased by say 10%. The new NPV will be as follows: NPV = -10,00, (1.1) (1.1) 2 (1.1) 3 = -10,00, ,27, ,46, ,05,710 = 1,79,263 NPV decrease (%) = 3,10,293-1, 79,263X 100 = 42.22% 3, 10,293

30 (d) Initial outlay : If initial outlay increased by say 10%. The new NPV will be as follows: NPV = -11,00, , , , (1.1) 2 (1.1) 3 = -11,00, ,63, ,95, ,50,789 = 2,10,293 NPV decrease (%) = (3,10,293-2,10,293)/3,10,293X 100 = 32.22%

31 (e) Project lifetime : Present value for 1 st two years. = - 10,00, ,00,000 x ,00,000 x = - 10,00, ,63, ,95,600 = - 10,00, ,59,200 = - 1,40,800 The project needs to run for some part of the third year so that the present value of return is Rs 1,40,800. It can be computed as follows: (i) 30,000 units x Rs 20 x = Rs 4,50,600

32 (ii) Per day Production in (Rs) assuming a year of 360 days = Rs 4, 50, = 1,252 (iii) Days needed to recover Rs 1,40,800 = 1, 40,800 1,252 =112 Thus, if the project runs for 2 years and 112 days then break even would be achieved.

The Textile Manufacturing Company Ltd., is considering one of two mutually exclusive proposals, Projects M and N, which require cash outlays of Rs 8,50,000 and Rs 8,25,000 respectively.

33 The Textile Manufacturing Company Ltd., is considering one of two mutually exclusive proposals, Projects M and N, which require cash outlays of Rs 8,50,000 and Rs 8,25,000 respectively. The certainty-equivalent (C.E) approach is used in incorporating risk in capital budgeting decisions. The current yield on government bonds is 6% and this is used as the risk free rate. The expected net cash flows and their certainty equivalents are as follows:

34 Year Project M Project N Cash Flow C.E. Cash Flow C.E. (Rs) (Rs) 1 4,50, ,50, ,00, ,50, ,00, ,00, Present value factors of Re. 1 discounted at 6% at the end of year 1, 2 and 3 are 0.943, and respectively. Required: (a) Which project should be accepted? (b) If risk adjusted discount rate method is used, which project would be appraised with a higher rate and why?

35 (i) Statement Showing the Net Present Value of Project M Year end Cash Flow (Rs) (a) C.E. (b) Adjusted Cash flow (Rs) (c) = (a) (b) Present value factor at 6% (d) Total Present value (Rs) (e) = (c) (d) 1 4,50, ,60, ,39, ,00, ,50, ,11, ,00, ,50, ,10,000 8,60,980 Less: Initial Investment (8,50,000) Net Present Value 10,980

36 Statement Showing the Net Present Value of Project N Year end Cash Flow (Rs) (a) C.E. (b) Adjusted Cash flow (Rs) (c) = (a) (b) Present value factor at 6% (d) Total Present value (Rs) (e) = (c) (d) 1 4,50, ,05, ,81, ,50, ,60, ,20, ,00, ,50, ,94,000 Less: Initial Investment 9,96,315 (8,25,000) Net Present Value 1,71,315 Decision : Since the net present value of Project N is higher, so the project N should be accepted.

37 (ii) Certainty - Equivalent (C.E.) Co-efficient of Project M (2.0) is lower than Project N (2.4). This means Project M is riskier than Project N as "higher the riskiness of a cash flow, the lower will be the CE factor". If risk adjusted discount rate (RADR) method is used, Project M would be analyzed with a higher rate. RADR is based on the premise that riskiness of a proposal may be taken care of, by adjusting the discount rate. The cash flows from a more risky proposal should be discounted at a relatively higher discount rate as compared to other proposals whose cash flows are less risky. Any investor is basically risk averse. However, he may be ready to take risk provided he is rewarded for undertaking risk by higher returns. So, more risky the investment is, the greater would be the expected return. The expected return is expressed in terms of discount rate which is also the minimum required rate of return generated by a proposal if it is to be accepted. Therefore, there is a positive correlation between risk of a proposal and the discount rate.

38 Determine the risk adjusted net present value of the following projects: X Y Z Net cash outlays (Rs) 2,10,000 1,20,000 1,00,000 Project life 5 years 5 years 5 years Annual Cash inflow (Rs) 70,000 42,000 30,000 Coefficient of variation

39 The Company selects the risk-adjusted rate of discount on the basis of the coefficient of variation: Coefficient of Variation Risk-Adjusted Rate of Return P.V. Factor 1 to 5 years At risk adjusted rate of discount % % % % % % More than % 2.689

40 Statement showing the determination of the risk adjusted net present value Projects Net cash outlays Coefficient of variation Risk adjusted discount rate Annual cash inflow PV factor 1-5 years Discounted cash inflow Rs Rs Rs Rs Net present value (i) (ii) (iii) (iv) (v) (vi) (vii) = (v) (viii) = (vii) (vi) (ii) X 2,10, % 70, ,29,180 19,180 Y 1,20, % 42, ,44,186 24,186 Z 1,00, % 30, ,08,150 8,150

41 New Projects Ltd. is evaluating 3 projects, P-I, P-II, P-III. Following information is available in respect of these projects: P-I P-II P-III Cost Rs 15,00,000 Rs 11,00,000 Rs 19,00,000 Inflows-Year 1 6,00,000 6,00,000 4,00,000 Year 2 6,00,000 4,00,000 6,00,000 Year 3 6,00,000 5,00,000 8,00,000 Year 4 6,00,000 2,00,000 12,00,000 Risk Index Minimum required rate of return of the firm is 15% and applicable tax rate is 40%. The risk free interest rate is 10%. Required: Find out the risk-adjusted discount rate (RADR) for these projects. Which project is the best?

42 (i) The risk free rate of interest and risk factor for each of the projects are given. The risk adjusted discount rate (RADR) for different projects can be found on the basis of CAPM as follows: Required Rate of Return = I Rf + (ke-i RF ) Risk Factor Where I rf = Risk free rate ke = Cost of Capital For P-I : RADR = ( ) 1.80 = 19% For P-II : RADR = ( ) 1.00 = 15 % For P-III : RADR = ( ) 0.60 = 13 %

43 The three projects can now be evaluated at 19%, 15% and 13% discount rate as follows: Project P-I Annual Inflows Rs 6,00,000 PVAF (19 %, 4) PV of Inflows (Rs 6,00,000 x ) Rs 15,83,400 Less: Cost of Investment Rs 15,00,000 Net Present Value Rs 83,400

44 Project P-II Year Cash Inflow (Rs) PVF (15%,n) PV (Rs) 1 6,00, ,22, ,00, ,02, ,00, ,29, ,00, ,14,400 Total Present Value 12,67,800 Less: Cost of Investment (11,00,000) Net Present Value 1,67,800

45 Project P-III Year Cash Inflow (Rs) PVF (13%,n) PV (Rs) 1 4,00, ,54, ,00, ,69, ,00, ,54, ,00, ,35,600 Total Present Value 21,13,800 Less: Cost of Investment 19,00,000 Net Present Value 2,13,800 Project P-III has highest NPV. So, it should be accepted by the firm

46 Internal Rate of Return Miscellaneous Sums

SOLUTIONS TO ASSIGNMENT PROBLEMS. Problem No.1 10,000 5,000 15,000 20,000. Problem No.2. Problem No.3

MASTER MINDS No. for CA/CWA & MEC/CEC. CAPITAL BUDGETING SOLUTIONS TO ASSIGNMENT PROBLEMS Problem No. Calculation of ARR for machine A and B: Machine A Step : Average Profit After Tax 5,, 5,, 5, Total